Chaos and the crystal ball

By Kim Stephenson

It sounds simple to invest successfully. But without a crystal ball it is extremely difficult. And one of the biggest problems is that, being human, we think we can predict and that by throwing money and intellect at any problem we can “solve” it.

So we make our problems worse by not accepting uncertainty and gambling on perfect prediction.

Investing is simple – in theory. You buy low and sell high. Therefore you need to know price relative to real value.  And that is where it becomes difficult. Value is what people will pay. What people will pay depends on what they think people will pay in future, which means that to invest, you have to predict the future.

As there are huge rewards for success, massive investment in sophisticated equipment, hiring of rocket scientists – the physicists who can use complex mathematics to model markets – you would expect that it gets done very well.

The index of a market is basically an average of the performance of the shares within it. As with any average, you would expect that about half of shares, or funds, would be above the average and half below.  So in a year, the probability of beating the index would be 0.5, and in any period, the probability of beating the average by pure chance each year would be 0.5 to the power of the number of years.

Werner De Bondt, a professor of finance at Chicago, pointed out a few years ago that index funds (ones that simply track the index) beat 75% of actively managed funds over virtually any time period. But half of the remaining funds (or 12.5%) that outperform their relevant benchmark do so just as a matter of chance. And of course, those figures don’t allow for the fact that failed funds are often folded or merged so the active funds are even worse than it looks.

Why, when there are all these experts, all this technology, all this investment in getting it right, can’t the predictions allow experts to buy low and sell high at least as often as chance?

One problem is that we’re not trying to calculate real value. Imagine a talent show where you get a prize for voting for the eventual winner. The eventual winner will be the one who gets the most votes. You happen to like contestant A. You know that your friends prefer contestants B or C.

Will you vote for A, knowing that they probably won’t win and you won’t win the prize? Vote for B or C, knowing that they are more popular and therefore more likely to win?  Or vote for, say F, because you’ve read that they are the sole support of their aged mother and you think that most people will like them and vote for them?

Whatever you do, notice that you don’t care about who is the “best” any more, you are thinking about “who do other people think is the best”, or more accurately “who are they going to vote for”? The real “value” is irrelevant, you’re trying to read the mind of everybody else, work out who will win and vote accordingly. The same thing happens in markets (and helps to trigger “bubbles”).

Another problem is, put simply, chaos.

Weather is a good example. We can predict some things, like monsoons, and local weather a few hours ahead. But we can’t reliably predict exact details several days ahead, there are just too many sensitive variables. Added to this is the problem that we think we have perfect understanding of the past.

Everybody thinks they can now explain the economic crash, say what caused it, what should have been done, how all the factors interacted. But a point made by Taleb in ‘The Black Swan’ is that if you ask people to describe the pool of water that will form from a melting ice-cube, they can do it, test whether they are right and most of the knowledgeable ones will give the same, single correct answer.

If you show them a pool of water and ask them what shape the ice-cube was, they can’t test whether they were right, don’t all give the same answer and nobody actually knows whether any of the explanations were right. In reality, markets are like that.

We can persuade ourselves that our explanation of why a share or an industry rose or fell is the only correct one, but the reality is that we have no idea. Perhaps a butterfly flapping its wings across the world caused somebody to pause to look at its beauty, thus they avoided the accident that would have stopped them attending a meeting, that would have sent a vote the other way, that would have… who knows. There are trillions of these incidents every day, most have no impact, some have a huge impact but even afterwards we don’t know for certain which was which.

We can say that, statistically, these incidents are unlikely to affect things. And using a normal distribution that is true. But markets don’t follow a normal distribution. Their movements are more like a power law distribution.

If the super-volcano under Yosemite National Park erupts it would have a huge impact on life on this planet. It might explode tomorrow, or not for 10,000 years. Volcanic eruptions follow a power law, huge events are rarer than smaller ones, but they don’t follow normal distributions. Nor do markets and most of the movement in a year is contained in a few days – drop out for a few days to avoid the fall you expect and you might miss the biggest rise of the decade.

It does sound simple to invest successfully. But it isn’t an exact science and without a really effective crystal ball, the nature of markets, chaos, hindsight bias and lots of other factors make it extremely unpredictable.

And one of the biggest problems is that, being human, we like to think we can predict and that by throwing money and intellect at the problem we can “solve” it. So we make our problems worse by not accepting uncertainty and gambling on perfect prediction.

(Business Psychology consultant and financial advisor Kim Stephenson, CPsychol, ACII, DipPFS is a unique combination of chartered occupational psychologist and qualified financial advisor, working in the UK.  Kim, author of the finance book Taming the Pound (to be published in 2011), has just launched the financial psychology website of the same name, Tamingthepound.com. He contributes regularly to media on psychological issues surrounding money, and has been featured in The Guardian, Citywire, BBC radio and Sense, the Royal Bank of Scotland customer magazine.)